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Long-term investing as a theme has become increasingly prominent. Long-term investing, as defined by the World Economic Forum, is “investing with the expectation of holding an asset for an indefinite period of time by an investor with the capability to do so.” In essence, it is investment carried out over years, and sometimes decades or generations, by institutions such as endowments and foundations, family offices, insurance companies, pension funds and sovereign wealth funds.
Long-term investors can play a stabilizing role in financial markets and an important role in funding long-term corporate growth and the development of infrastructure. However, there are numerous obstacles that can prevent long-term investors from investing for the long-term.
The Forum has estimated that of the roughly US$ 27 trillion in assets managed by long-term investors, only US$ 6.5 trillion is available for long-term investments. Liability constraints reduce the long-term capital pool by an estimated US$ 15 trillion. For institutions such as pension funds and insurers, assets are required to fund obligations in the near term and thus cannot have an indefinite horizon. Additional constraints such as risk appetite, taking account of funding ratios, capital requirements and mark-to-market accounting as well as softer decision-making constraints such as principal-agent concerns further limit the amount of capital available long-term investments by US$ 5.5 trillion, according to Forum estimates.
The Global Agenda Council on Long-term Investing has played a key role setting the intellectual framework for Forum-led discussions around long-term investing, while concentrating on how to overcome obstacles. Over the 2011-2012 term the Council:
- Oversaw the publication of a detailed report on measurement and governance issues impacting the ability of long-term investors to be long-term
- Focused on governance and policy, building on the Forum’s prior work on long-term investing.
Governance was looked at through the lens of how long-term investors are governed (e.g. the role of a board overseeing a public pension fund) and how long-term investors are managed internally (e.g. balancing periodic internal performance assessment of staff with long-term investment horizons). The primary deliverable of the Council in turn was a report on Measurement, Governance and Long-term Investing. The report explores how challenges in measuring long-term investment values and returns, risks and liabilities intersect with the governance of long-term investors themselves. The report argues that without effective governance, measurement schemes can distort decision-making around which investments are chosen and the time frame over which they are held. Yet the lack of meaningful, intuitive measurements for performance and risk over long time horizons adds more complexity to long-term investing and the governance of such efforts. Research for the report was led by Council member Josh Lerner of Harvard Business School. The members of the Global Agenda Council on Long-term Investing provided intellectual guidance and oversight for the report, serving in effect as a steering committee.
The report has been picked up by leading industry publications, such as Institutional Investor, and is expected to help to shape the broader debate on measurement and governance issues (among both policy-makers and practitioners).
Long-term investment strategies in public and private assets present significant measurement issues. Inaccurate measurement of performance and risk can create substantial distortions. Whether investors believe their positions will bring higher or lower returns than they eventually produce and with more or less risk, the consequences of portfolio misallocation can be enduring. The measurement tools currently available are not well suited to assessing long-term investments. The traditional metrics for return calculation, such as internal rates of return, cash-on-cash calculations and public market equivalents, have drawbacks. Methods of valuing portfolios, such as mark-to-market and historical accounting approaches, can introduce distortions when assessing long-term investments if their limitations are not understood. Finally, as the 2008 financial crisis highlighted, risks of all types need to be considered more carefully. Examples of the impact of distorted risk measurement include:
- Market risk The purported lower volatility of private assets often results from stale prices rather than true non-correlation and can lead to underestimation of a portfolio’s risk, with negative consequences for asset allocation and performance. Yet marking these assets to market on a frequent basis may highlight volatility and increase pro-cyclical pressure.
- Illiquidity risk If the full amount of capital committed to a long-term illiquid investment position is not correctly assessed, illiquidity risk can present cash flow pressure.
- Liability risk For some long-term investors, excessively optimistic statements about future returns relative to their liabilities can introduce significant distortions to investment decisions. Poor assessment of these risks and misapplication of the metrics at hand can lead to results that do not match expectations and impose costs on society at large.
Misunderstanding these risks affects asset allocation, time horizons and an organization’s willingness to commit to a long-term investment strategy. To manage these risks, many institutions employ various types of measurement. Some, such as internal rate of return (IRR), cash-on-cash returns and public market equivalents, measure returns from long-term investments. Others, such as mark-to-market methodologies and the reliance on historic cost, measure valuation. Each metric is definitely useful, but also suffers from undeniable shortcomings, as demonstrated during the crisis of 2008. Some boards remained committed to a long-term strategy and encouraged staff to take advantage of short-run valuation distortions. Others panicked at the reported losses and abandoned long-term strategies, selling illiquid positions at the worst possible moment. The board overseeing a long-term investment programme needs to be committed to that strategy. Yet the current measurement tools available make governance, with its understandable need for transparent reporting and short-term performance measurement, extremely challenging.
The governance of long-term investors is critically important. Governing bodies have a wide-ranging impact on the ability of an organization to pursue a long-term investment strategy, starting with the way these groups are recruited and structured. The responsibilities of governing bodies include:
- Adoption of a strategy The board approves the group’s investment strategy and must defend it during market downturns. Without a strong commitment, an ostensibly long-term strategy can devolve into short-term trend chasing as the group adopts those strategies that are in favour at the moment.
- Choice of metrics and time horizon The board is involved in the choice of metrics and the time horizon over which they are reported. Quarterly reports may be required but they can be linked to longer-term measurements, such as five- or ten-year forecasts or ranges of performance.
- Risk and selection assessment Inadequate measurement systems make it difficult for the board to fully understand the risks assumed when entering into long-term contracts with investment managers.
- Establishment or approval of staff compensation systems Without a clear incentive for a long-term orientation (whether a bonus or simply an understanding of short-term market fluctuations), staff will tend to focus on short-term performance because it is easier to measure and can be expected to pose less career risk.
The Intersection of Measurement and Governance
The success of a long-term investment strategy relies on both measurement and governance: the board’s choice and careful application of the best available metrics. Measurement plays an important role in financial modelling and portfolio management. But without a clear understanding of the characteristics of the measurement techniques and their advantages and drawbacks, any of these metrics can mislead groups attempting to pursue a long-term investment programme.
Measurement and governance have a counterintuitive relationship. In some situations, the best way to correct poor performance is to measure more things more often. Yet too frequent valuation information on long-term investments may be counterproductive. If all investment committees and investors were dispassionate investors, introducing additional data should be beneficial. But excessively frequent measurement – and the consequent focus on near-term liquidity events – seems to introduce a short-term orientation that may distort long-term investments. If an investor has no intention or need to sell an asset, frequent valuations may lead to decisions that are not in an investor’s long-term best interests. A wholesale drop in public markets will undoubtedly reduce the value of a portfolio that is marked-to-market. If the investor plans to hold the assets for decades, the truly long-term investor might wish to buy into the depressed market. But a combination of regulatory pressures and human psychology may lead to pressures on the organization to do the opposite, whether due to lack of commitment to a long-term strategy or to public pressure. Such behaviour ends up defeating the entire purpose of long-term investing.
Recommendations Made in the Report
The central conclusion and recommendation of the report is that governing bodies and other external stakeholders need to act on the understanding that the performance of long-term investments unfolds over time periods longer than the quarter or the year, even when short-term measurements are used. Short-term metrics applied to long-term investments must be understood in a long-term context, for instance, an annual measure in reference to a long-term growth path that expects variation on either side.
Governance intersects with measurement in the choice, defence and interpretation of metrics that provide important guidance to a long-term programme without adding a short-term time horizon. Within that broad context, research and conversations with many long-term investors led to eight recommendations. While they directly address investors, these recommendations also contain a message for policy-makers in creating regulations and structures in which sound long-term investment practices can flourish. Four of the recommendations address measurements for long-term investment and four concern governance structures to encourage long-term investment. However, there is substantial overlap across all of them. Without supportive governance, few long-term investment programmes would be viable; without thoughtful measurement, accurate assessment and required interim adjustments would not be possible.
- Commit to a long-term programme and use long-term measurements. Accepting and defining a long-term perspective can set expectations, as when Australia’s sovereign wealth fund announced that performance would be measured over a rolling 10-year period although the fund’s managers would report results on a quarterly basis. The longer time horizon, along with a strategy to invest across six broadly defined asset classes, provided the fund with greater flexibility. For the year ending 30 June 2011 the fund surpassed its benchmark of 4.5% above Australia’s Consumer Price Index by a margin of 4.7 percentage points. Paradoxically, commitment to a defined programme provides flexibility to operate within it.
- Focus on a limited number of measurement metrics. Individual funds should determine a simple group of metrics that will provide the information they need to make appropriate investment decisions. Reams of data that cannot be acted upon are not information but inconveniences.
- Don’t worry about precision; just try to be directionally correct. “We’d rather be precisely wrong than roughly right” is a dangerous waste of energy. Although risk measurement is difficult, risk is ignored at one’s peril, as many investors discovered in 2008 and 2009. Being consistent and transparent about an approximate value for risk is preferable to either ignoring it or spending excessive energy on precise but short-lived quantifications.
- Adopt a critical perspective. Many of the most successful long-term investors have somewhat of an academic orientation, which leads to a process of periodic self-evaluation. Many of these funds will occasionally stop to consider the processes that led them to make investments that proved to be particularly successful or problematic. By moving away from traditional metrics of success (e.g. rate of return), they can see their activities in a way that is less likely to be affected by measurement issues.
- Encourage stable teams. It is critical to have talented well-staffed teams. If a group does not have a stable team, or lacks the resources to perform hands-on due diligence, it is unlikely to be regarded as a credible investor. Staff with considerable experience and a long tenure offer many benefits for a long-term oriented investment institution. The shared experiences of such staff members provide a common background that helps them undertake complex investment decisions and to think long-term.
- Design a system of rewards and protections for staff to encourage appropriate risk-taking. Another important characteristic of a good team is the ability to make its own decisions and establish a track record in an asset class over a reasonable period of time. This quality is very much linked to the rewards that staff members receive. Compensation does not seem to be a matter of paying more so much as providing the non-pecuniary benefits that come from being a part of a community, as well as a strong sense of mission associated with their work. In the ideal environment, staff will feel comfortable taking responsible risks in support of the institution’s long-term future: comfortable that they will be protected from criticism of a short-term downturn related to a long-term strategy.
- Create or attract a professional board. An active and professional board or investment committee can make an enormous difference in implementing a long-term investment strategy. The individuals should have a background suited to (although not necessarily expert in) institutional investment management. The most effective of these bodies see their role not as micromanaging the decisions of the investment staff but rather in setting broad policy directions and strategic investment goals. The board can also help to provide advice for the staff as it grapples with challenges. A board with a solid long-term orientation can ignore the noise of short-term market movements and focus on long-term growth and opportunity. They can also help shelter the organization from pro-cyclical investment pressures. Board members need to serve extended terms to accomplish these goals. The governance of the investment effort can contribute to creating an environment that nurtures talent and encourages a long-term perspective.
- Be a desirable investor. Building a brand as a desirable investor helps an organization access desirable fund managers and attract talented people. Since the liquidity pressures that many experienced during the crisis, there has been a greater emphasis on having a variety of desirable investors. The key elements that seem to be associated with desirability include stability of the management team, considerable liquidity and resources and an ongoing organizational commitment to long-term investing.
Over the coming year, the Council expects to continue its work around the themes of governance and policy as well as to deepen its engagement with other councils in the Global Agenda Council network. Other councils especially those related to the recipients of capital such as the Global Agenda Council on Infrastructure and Urban Development and the Global Agenda Council on the Role of Business can provide valuable perspectives and are natural partners to explore ways to overcome the obstacles that reduce the supply of long-term capital.
The opinions expressed here are those of the individual members of the Council and not of the World Economic Forum or any institutions to which they are affiliated.